DEFLATION. – A phenomenon whereby the volume of the means of payment, for various reasons, decreases in relation to the mass of goods being exchanged.
In order to understand deflation in its scope and effects, it is necessary to begin with the so-called equation of exchange, which essentially serves to bring to light the relationship connecting the amount of the means of payment on the one hand, and the total of the goods exchanged on the other, with the general level of prices. Its formulation is: the volume of money is equal to the general level of prices multiplied by the quantity of goods exchanged. It is
immediately apparent that there is a direct proportionality between the level of prices and the volume of money, whereas there is an inverse proportionality between the level of prices and the mass of goods being exchanged. This emerges from the transformation of the formula, according to which the general level of prices is equal to the ratio between the volume of money and the quantity of goods exchanged. Strictly speaking, therefore, a decrease in the general level of prices may result either from a decrease in the volume of money or from an increase in the mass of goods exchanged. Apart from exceptional cases (wars, earthquakes, etc.), this second factor is normally stable, varying significantly only over long periods of time. The amount of the means of payment, however, may undergo substantial contractions, while the other factor remains unchanged; and it is generally to this phenomenon that almost all deflations observed thus far must be attributed. It must therefore be held that deflation consists more in an absolute decrease in the volume of money than in a relative decrease resulting from an increase in the mass of goods. It is worth recalling that one can speak of a genuine deflationary process only when it reaches such an intensity as to affect the level of prices through a decline of some significance.
Whereas the expansion of the monetary circulation, that is, inflation, is usually not deliberately undertaken by the responsible authorities, deflation is in every case a voluntary and conscious act. Deflationary policy normally aims to restore currencies, depreciated by inflation, to their previous value or in any case to a higher value, when the more limited objective of monetary stabilization is considered insufficient. After the war of 1914–18, several countries that had suffered severe devaluations adopted deflationary policy, including Italy; but it was England in particular that pursued this experiment most thoroughly. As some economists had warned, the results achieved, when they were achieved, entailed painful sacrifices and provoked profound crises of adjustment. Indeed, since entrepreneurs usually bear a large part of the costs of production before the finished articles are sold and are often bound by long-term contracts, a decline in prices is not accompanied by an immediate decrease in costs, and the activity of firms consequently results in losses. This causes, on the one hand, a slowdown—which may lead to paralysis—in the pace of production and, on the other, the emergence or worsening of unemployment in every category of those employed in production. At that time, however, it was maintained that deflation was necessary to remedy the injustices that had arisen in the distribution of wealth and income as a result of monetary devaluations. It is well known, in fact, that inflation harms creditors and benefits debtors; and while it benefits the economically active categories of entrepreneurs and merchants, it instead jeopardizes the position of those who receive fixed incomes. Apart from the drawbacks mentioned, it was found that deflation is counterproductive in this respect, in practice consolidating the advantages gained through inflation, while normally—especially through unemployment—it aggravates the losses of those classes in whose favor improved justice is invoked.
Recourse to deflationary measures is, however, legitimate and useful when the intention is to remedy, by lowering the domestic price level, an imbalance that has arisen in relation to the movement of international prices.